Beware Mean Reversion: The Market Is Poised To Fall

Includes: GLD, SP500
by: Ram Adapa

The Federal Reserve expects US Real GDP growth to fall over the next several years.

The market is trading in excess of its long-term linear trend with real GDP by roughly 25%.

With the expected slowed growth in RGDP in combination with trend reversion, I expect the market to fall substantially in the coming years.

I recommend a long position in gold as the commodity has a near zero-correlation relative to the market to preserve capital during the impending fall.

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I recommend a long position in gold (NYSEARCA:GLD) to preserve capital in the impending US economic slowdown. Using a back-of-the-napkin univariate regression, the market is currently overvalued by ~25% relative to its long-term relationship with real GDP (RGDP). I expect the long-term relationship to reestablish itself over the next two years as RGDP growth slows down and mean reversion occurs due to investors losing sentimental exuberance. Given that gold has, over the past ~20 years, held a near zero-correlation to the market, I believe it is a solid hedge to preserve capital during the impending market slowdown.

The Federal Reserve, being at the forefront of economic news and economic data analysis has begun to take a noticeably bearish tone regarding RGDP growth in the U.S. Comparing the previous December 2018 statement by the Federal Open Market Committee (FOMC) to the more recently issued January 2019 statement, there were notable shifts in terminology that subtly indicated a slowdown in the American economy. Where the December statement indicated economic activity had been rising at a "strong rate," the January statement changed by utilizing the weaker term "solid" instead.

Earlier the committee had been deemed "further gradual increases in the target range for the federal funds rate [to be] consistent with sustained expansion of economic activity, [and] strong labor market conditions," the FOMC has noticeably altered course by easing off on rate increases and calling for "patience" before further rate hikes are implemented. As a result, the Federal Reserve continues to operate within a 2.25% to 2.50% target range for the Federal Funds rate. The Federal Reserve typically only implements a target rate hike when they see the economy overheating and conversely initiates a target rate halt or rate drop when they see economic activity stagnating/contracting.

Source: FOMC December Minutes

Additionally, I see a noticeable negative tone regarding US RGDP prospects by the FOMC. The Fed lowered its 2019 RGDP growth expectations from an estimated 2.5% growth rate in the September projection materials to a 2.3% growth rate in the December projection materials. The range has likewise been revised by 10 basis points downwards on both ends of the spectrum. The FOMC currently sees a range between 2.0% to 2.7% for a change in RGDP, whereas the September range fell between 2.1% to 2.8%. Maybe even more ominous is the downward trend from 2018 to 2021 in RGDP growth expectations. The FOMC in their December minutes shows RGDP growth falling from 3% in 2018 down to a mere 1.8% by 2021. To put 1.8% in perspective, the average annual RGDP growth for the last 10 years (which included the recession) is 1.8%, the 20 year average is 2.2%, and the 50 year average is 2.8%.

Though the projections of FOMC are all still positive values, I believe the slowdown in growth will force the market to realize its current, probably sentimental-irrational-exuberance-driven, overvaluation. This slowing will most likely take the wind out of investors' sails, which will then help bring the market back in line with its historic relationship with RGDP.

The Fed isn't the only major player that has lowered its growth expectations for the coming years. Duke University did a study of CFO's perceptions of an upcoming recession and found that just under 50% of the CFOs surveyed believe I will go into a recession by end of 2019, and 82% believed we'd be in a recession by the end of 2020. Given this perception, companies may be trying to "ease" their way into a slowdown by trimming costs and their workforce early. If the survey is representative of all CFO sentiment, then I expect to see more conservative corporate behavior, which may ultimately lead to a "self-fulfilling prophecy" slowdown. Even Wall Street itself has revised its growth expectations downwards. Analysts have lowered their forecasts for S&P 500 profits to fall by 1.7 % in Q1 of 2019 relative to Q1 of 2018. The average expected EPS of the S&P500 was lowered from $40.21 in December 2018 to $37.95 in February 2019, representing a 5.6% drop.

Given the aforementioned expectation for US RGDP to decline as well as the supporting sentiment by Corporate America and Wall Street, I built a very simple model to describe the relationship between the SP500 and RGDP (I fully understand that a formal multivariate, time-series regression on S&P percent returns would be a much better model. Our aim in this study was to provide a simple to understand, quick visual and rough estimate of expected decline in the S&P. I acknowledge the model is poorly specified, non-controlling, heteroskedastic, etc.). By regressing quarterly levels of RGDP on S&P levels, a positive and tight relationship (correlation of .88) is easily observed.

Sources: FRED; Yahoo Finance

I took the FOMC's latest forward projections on RGDP and forecasted quarterly RGDP levels extending to Q4 of 2021. Using the univariate regression above, I estimated what the SP500 should be given the forecasted level of RGDP. As one can easily see, we are currently sitting well above the historic trendline. If the economy were to continue at its current pace, it wouldn't be far-fetched to assume the stock market would still carry the current "exuberance premium." However, with the forecasted slowing rates, I believe the market will gradually lose its excitement and mean revert back in line with its historic relationship. According to the loose model, the expected value of the SP500 at the end of Q1 of 2019 is $2,089.43, implying the market is in excess of expectation by >25% at its current value of $2,803.69 (3/1/2019). I don't expect this correction to occur immediately, but I do expect the reversion to occur over the next two years as the lack of excitement gradually erodes investors' optimism.

Sources: FRED; Yahoo Finance; Team Estimates

Given the substantial expected decline in the SP500, I believe the best hedge is gold. The commodity has historically proven to be a safe-haven to store wealth while the financial markets deteriorate. Over the past 20 years, gold has held a mere .03 correlation with the SP500. The gold bullion is currently trading at suppressed levels of $1,309.95 relative to its high during the Great Recession of $1,896.50, a 31% discount, primarily due to the optimism generated by the prospective trade deal between the US and China and a strong USD. For fellow bears, now might be a good time to scale out of equity and into gold. What goes up, must come down - and gold will be there to catch you in its shiny, loving, stubby bullion arms.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.